Ever since Bill Ackman made his lengthy presentation on December 20, 2012, defending his 20 million share short position in Herbalife Ltd. (HLF), much press and speculation has been made about the so-called "Mother of all short squeezes". There have been a litany of analyst reports and press speculation (See this Bloomberg article, this Barron's blogpost, this FT article, or this Reuters article) about Herbalife's ability to repurchase a large quantity of shares or a take-private transaction which would lead to a massive squeeze on Bill Ackman's 20 million share position. I don't think Herbalife has the ability to do any of these shareholder-friendly transactions which would lead to this "Mother of all short squeezes". After some consideration and explanation, I will offer an alternative scenario that could engineer this "Mother of all short squeezes".
I disagree with the hypothesis that Herbalife will recapitalize its balance sheet either publicly or privately as contemplated above, because I don't believe Herbalife has the ability to access the debt capital markets. While I have no current knowledge of what will or will not gain approval from a Wall Street bank's high yield committee as I am not employed in the sector, I have a hard time believing any creditor would risk their capital lending into Herbalife. Even in today's yield-starved environment I imagine most underwriters would not want the reputational risk associated with arranging a debt package for Herbalife, only to see Bill Ackman's thorough analysis be proved true some time in the next 36 months.
For a debt investor, there is only downside lending money to Herbalife from here, as Bill Ackman will be either right or wrong. If Bill Ackman is right and the FTC decides Herbalife is a pyramid scheme, the business will vaporize overnight and debt investors will face likely impairment as the Company has very few tangible assets to speak of and will no longer be a going concern. If Bill Ackman is wrong, and the Company trades back to a normal level of 7.8x forward EBITDA (its 10 year average forward EBITDA multiple), the stock should trade to ~$55 a share returning 44% to equity holders, from Friday's close of $38.74. Debt holders will only receive par in return, despite coming to the Company's rescue during a time of need. Given the abundance of headline risk, I don't believe the debt capital markets will be overly generous, or existent, when it comes to financing a shareholder-friendly transaction such as a leveraged recapitalization or leveraged buyout.
Accordingly, the only way, in my opinion for a short squeeze to occur, outside of a share repurchase or LBO, is for Herbalife to incentivize shareholders to exchange out their existing shares with something else. If Herbalife were to figure out a way to convince shareholders to tender their shares, stock holders would then call back any shares lent out to participate in whatever exchange Herbalife was offering.
I now offer my thoughts on how this could be accomplished.
The first is a page out of previous HLF short-seller's current playbook. David Einhorn is in the market trying to convince Apple's (NASDAQ:AAPL) Board of Directors to effect a leveraged recapitalization by the use of his GO-UP (Greenlight Opportunistic Use of Preferreds) strategy. There is distinct similarity between Apple and Herbalife that would necessitate the use of such a strategy, the lack of access to the debt capital markets.
Before I get flamed for suggesting Apple does not have access to the debt capital markets, I simply mean on the scale of what David Einhorn is proposing. On paper Apple is one of the most creditworthy companies in the world, if not the most creditworthy. I am sure the debt market would have tremendous appetite for Apple bonds. Mr. Einhorn has suggested Apple issue anywhere from $50-$500 billion in preferred shares. An offering of this size would grow the entire corporate debt market 1.5%-15% depending on the size. And even if Apple were to sell a considerable amount of debt, say $100 billion, representing 2x gross leverage and negative net leverage, to repurchase shares in the open market, this would likely take a while for the bond market to digest.
For all of the aforementioned reasons, Apple could have difficulty executing a large-scale debt-financed share repurchase. The preferred share route elegantly solves any execution issues by pushing the quasi-debt preferred shares onto the common shareholders. This acts in kind as a leveraged share repurchase, because the company has levered its balance sheet without having to borrow money and repurchase shares in the open market.
Getting back to Herbalife, the GO-UPs would work to leverage HLF's balance sheet without having access to the debt capital markets. The Company could use perpetual preferred stock to perform an in-kind share repurchase. The glaring issue with this tactic is that it has done nothing to ward off Mr. Ackman. Simply pushing out the preferred stock to common holders on its own right would not cause large stockholders and lenders of shares to call back their holdings.
So, if Herbalife were interested in executing a shareholder-friendly transaction that would have the added benefit of causing pain to common stock short-sellers, they would need to take Mr. Einhorn's GO-UPs a step further and offer common shareholders the ability to exchange out their shares, which currently yield just over 3%, for something much juicier. How does a 6% yield and all the economic upside of common stock sound?
A 6% convertible participating preferred would accomplish just that. It would give current equity holders the incentive to trade out their 3% common shares for 6% preferred shares that have full common equity upside. Stock lenders would realize the economic incentive (6% is better than 3%) to call back their shares immediately, which would lead to the massive short squeeze that the media keeps describing.
If there are concerns about certain mutual funds' ability to own preferred stock, then Herbalife could issue a simple 6% perpetual preferred stock with penny warrants attached to mirror each common shareholder's economic exposure.
For full disclosure, I am neither long nor short any securities of Herbalife Ltd. and I have no current plans to express a view on Herbalife shares. I am not offering any kind of investment advice, just a market observation.